Production, Opportunity Cost and Relative Price the Economic Problem

Lecture 2

Production, Opportunity Cost and Relative Price

Eric Doviak Principles of Microeconomics

The Economic Problem x What will be produced? o Basic needs: food, clothing, shelter, etc. o Non-essentials: fish tanks, televisions, etc. o Capital goods: machinery, tools, human skills, etc. to produce more in the future x How will it be produced? o What resources are available? o How should labor and capital be allocated the production of each of the various products? x Who will get what is produced? o How should the products be allocated to the members of society – individuals, businesses, government, etc.?

Page 23 Comparative Advantage

This is one of the very few economic principles which is undeniably true, but is not obvious to intelligent people. x The US has a comparative advantage in the production of a good, if the opportunity cost of producing that good is lower in the US than it is in other countries. o Opportunity cost – how much of one good you have to give up in order to gain more of another. o Unit labor requirement – amount of labor 1hour hour needed to produce one unit of a good. Ex. If I 0.5 page type 2 pages of notes per hour, then my unit 2 pages labor requirement (to type one page) is half an hour per page. x Countries gain from trade, x if they specialize in producing the goods x in which they have a comparative advantage, x although there may be distributional effects to consider.

Comparative Advantage x Colleen can cut 12 logs a day or gather 10 bushels of food a day x Bill can only cut 5 logs a day or gather 8 bushels a day Colleen’s opportunity cost Bill’s opportunity cost x of cutting logs: x of cutting logs: 1day 1day 12 logs 5 logs 10 bushels 0.83 bushels 8 bushels 1.6 bushels 1day 12 logs log 1day 5 logs log 10 bushels 8 bushels x of gathering food: x of gathering food: 1day 1day 12 logs logs 5 logs logs 10 bushels 1.2 8 bushels 0.625 1day 10 bushels bushel 1day 8 bushels bushel 12 logs 5 logs x Colleen has a comparative advantage in cutting logs because her opportunity cost of cutting logs is less than Bill’s. x Bill has a comparative advantage in gathering food because his opportunity cost of gathering food is less than Colleen’s. Page 24 x Colleen has a comparative advantage in cutting logs. x Bill has a comparative advantage in gathering food. x Colleen has an ABSOLUTE advantage in the production of BOTH goods, but she has a COMPARATIVE advantage in the production of only ONE good (cut logs). Relative Price x If Colleen and Bill valued logs and food equally, then they would trade logs for food at a one-to-one ratio. x If you prefer to think in terms of dollar values: o let the price of logs be one dollar per log: $1/log o let the price of food be one dollar per bushel: $1/bushel x so that: $1/log o the relative price of logs is one bushel per log: 1 bushel $1/bushel log log o the relative price of food is one log per bushel: $1/bushel 1 $1/log bushel

Colleen’s Specialization Æ Cutting Logs x A person (country) should specialize in producing a good if its opportunity cost is less than the relative price of that good. o Colleen should specialize in logs because her opportunity cost of cutting logs is less than the relative price of logs. o By contrast, Bill should not cut logs because his opportunity cost of cutting logs is greater than the relative price of logs. Colleen's opp.cost of logs rel.price of logs Bill's opp.cost of logs 0.83 bushels 1 bushel 1.6 bushels log log log Colleen’s Gains from Trade x By specializing in cutting logs and trading her logs for food, Colleen gains more food (per day of work) than if she gathered food herself. 12 logs*1bushel 12 bushels ! 10 bushels 1day 1log 1day 1day

Page 25 Bill’s Specialization Æ Gathering Food x A person (country) should specialize in producing a good if its opportunity cost is less than the relative price of that good. o Colleen should not gather food because her opportunity cost of gathering food is greater than the relative price of food. o By contrast, Bill should gather food because his opportunity cost of gathering food is greater than the relative price of food. Colleen's opp.cost of food rel.price of food Bill's opp.cost of food 1.2 logs ! 1 log ! 0.625 logs bushel bushel bushel Bill’s Gains from Trade x By specializing in gathering and trading his food for logs, Bill gains more logs (per day of work) than if he cut logs himself. 8 bushels* 1log 8 logs ! 5 logs 1day 1bushel 1day 1day

Moral of the Story x Even though Colleen can produce both goods more efficiently, she gains by specializing in logs (the good in which she has a comparative advantage) and trading her logs for food with Bill. x Moral: America gains by trading with less developed countries. x Even though Bill is less efficient at producing both goods, he gains by specializing in food (the good in which he has a comparative advantage) and trading his food for logs with Colleen. x Moral: less developed countries gain by trading with America.

Lower Productivity Æ Lower Wage x Recall the dollar prices of each good: $1/bushel and $1/log o Colleen produces 12 logs per day, so her wage is $12 per day. o Bill produces 8 bushels per day, so his wage is $8 per day. x This is why the Malaysians who made your sneakers, receive a much lower wage than you do. They’re less productive.

Page 26 econ. data for 15 of the largest underdeveloped countries, 2001 GDP per Human Exports as Imports as country cap. at PPP Dev. Index % of GDP % of GDP Mexico $ 8,430 80.0 % 27.5 % 29.8 % Brazil $ 7,360 77.7 % 13.2 % 14.2 % Thailand $ 6,400 76.8 % 66.0 % 59.4 % Philippines $ 3,840 75.1 % 48.6 % 51.7 % Turkey $ 5,890 73.4 % 33.7 % 31.3 % China $ 4,020 72.1 % 25.5 % 23.1 % Iran $ 6,000 71.9 % 20.7 % 18.5 % Vietnam $ 2,070 68.8 % 54.6 % 57.0 % Indonesia $ 2,940 68.2 % 42.3 % 34.9 % Egypt $ 3,520 64.8 % 17.4 % 22.1 % India $ 2,840 59.0 % 13.5 % 14.1 % Bangladesh $ 1,610 50.2 % 15.4 % 21.5 % Pakistan $ 1,890 49.9 % 18.0 % 19.3 % Nigeria $ 850 46.3 % 43.3 % 34.4 % Ethiopia $ 810 35.9 % 15.1 % 29.8 % GDP per Human Exports as Imports as correlation matrix cap. at PPP Dev. Index % of GDP % of GDP GDP per cap. at PPP 1.000 Human Dev. Index 0.847 1.000 Exports as % of GDP 0.062 0.353 1.000 Imports as % of GDP –0.024 0.245 0.939 1.000 sources: World Development Indicators (2005); Human Development Report (2003)

Trading Up x Of the countries in the table above, the ones which have the highest levels of human development, are generally the ones that engage in more international trade. x the Human Development Index is positively correlated with: o a country’s share of exports in GDP o a country’s share of imports in GDP x the correlations are not perfect, but they are significant moral of the story x Countries gain from trade, x if they specialize in producing the goods x in which they have a comparative advantage, x although there may be distributional effects to consider: o workers who are not working in the sector where the country has a comparative advantage will be adversely affected by free trade o ex. in America steel workers, textile workers and farmers are adversely affected by trade Page 27 Production Possibilities Frontier x PPF – all combinations of goods that can be produced if resources are used efficiently. One can produce at or below the PPF, but not above it.

In one day, Colleen can: In one day, Bill can: x cut 12 logs or gather 10 bushels x cut 5 logs or gather 8 bushels x or produce a combination, such x or produce a combination, such as: 6 logs and 5 bushels. as: 2.5 logs and 4 bushels. Slope of the PPFs (above) is: –1*opp. cost of gathering food

Gains from Trade

log x Add a red line whose slope represents the relative price: 1 bushel

If Colleen specializes in cutting logs: If Bill specializes in gathering food: x she can trade some of her logs for x he can trade some of his bushels bushels of food and of food for logs and x consume a combination that x consume a combination that exceeds any combination that she exceeds any combination that he could produce on her own. could produce on his own. Page 28 Production Function

Quantity produced is a function of capital and labor: Q = f (K, L) x If you have one unit of kapital (for example, one stove in a kitchen), x and you keep increasing number of workers (labor) at that machine the quantity produced will increase x but at a decreasing rate Q = f (K, L) o because the workers start to get in each other’s way This production function is o “too many cooks in the kitchen” drawn for a fixed amount of capital.

x PPF represents: Production o all the possible combinations of goods (and services) Possibilities o that can be produced, o if resources are used efficiently. Frontier x Production possibilities are constrained by amount of labor and capital in the economy. x Cannot produce above PPF x If we shift labor from production of X and into production of Y, o less X will be produced o more Y will be produced x PPF summarizes opportunity cost of all such shifts. x If resources are not used efficiently o labor unemployment, o inefficient management x the economy is producing at a point below the PPF.

Page 29 Cuba’s Ten Million Ton Sugar Harvest x In the 1960s, Cuba produced about 6 to 7 million tons of sugar a year, which was sold primarily to countries in the Soviet bloc. x Beginning in 1969, Cuban dictator Fidel Castro sent hundreds of thousands of urban workers into the fields in an effort to produce 10 million tons of sugar in 1970. x Ultimately, Cuba missed its goal and only managed to produce 8.5 million tons – the largest harvest in Cuban history. What were the effects on Cuban economy? For simplicity, assume that before the plan: x Cuba produced 6 million tons of sugar and 5 million tons of "everything else" x relative price of sugar was one ton of everything else per ton of sugar, everything else x at a relative price of 1 sugar , Cuba traded 2 million tons of sugar for 2 million tons of everything else and x consumed 4 million tons of sugar and 7 million tons of everything else

massive disruptions in the Cuban economy

Since Cuba allocated all of its production to sugar, it produced at the "sugar corner" of its PPF. At that corner, the opportunity cost of producing sugar exceeds the relative price of sugar.

For simplicity, let's pretend that Cuba: x succeeded in producing all 10 million tons of sugar, but didn't produce anything else everything else x at a relative price of 1 sugar , Cuba traded 6 million tons of sugar for 6 million tons of everything else and x consumed 4 million tons of sugar and 6 million tons of everything else

So (in this example) Cubans consumed the same amount of sugar, but their consumption of everything else fell from 7 million tons to 6 million tons – a 15 percent decrease.

Page 30 sweet it wasn’t

Q: Would a 15 percent decrease in consumption of everything else a massive disruption in the economy? A: If you could consume the same amount of sugar that you did last year, but your consumption of everything else fell 15 percent, would you be happy?

lesson from Cuba’s experiment x a country should produce at the point along its PPF, where the opportunity cost of producing a good (ex. sugar) equals the relative price of that good x Cubans suffered because their country produced at a point where the opportunity cost of producing sugar exceeded the relative price of sugar x Similarly, had Cuba allocated all of its resources to producing “everything else” and produced no sugar it also would have suffered o because at such a point, the opportunity cost of producing everything else would have been greater than the relative price of everything else o (from the opposite perspective…) because at such a point, the opportunity cost of sugar would have been less than the relative price of sugar Why did Bill and Colleen completely specialize in one good? x A country should completely specialize in the production of one good o ONLY if the relative price of that good is greater than the country’s opportunity cost of producing it at every point along the PPF o Bill and Colleen’s opportunity cost was constant all along their PPFs x the PPF I drew for Cuba assumes increasing opportunity cost – i.e. Cuba’s opportunity cost of producing sugar increases as it produces more sugar Page 31